Thursday, August 22, 2019

SEC Complaint Against a VC Exempt Reporting Adviser

On August 13, 2019, the SEC filed a complaint against Stuart Frost and Frost Management Company, LLC for violating the antifraud provisions of Sections 206(1)-(2) and 206(4) of the Investment Advisers Act.  This case is a reminder that certain provisions of the Advisers Act apply to all investment fund managers, regardless of whether they are registered, non-registered, or exempt (exempt reporting advisers are referred to as "ERAs").  Also, this case highlights once more the importance of proper disclosure of management fees and expenses (and that they have to be reasonable and market).

Mr. Frost, through his investment management firm, managed five venture capital funds that raised about $63 million.  These funds were invested into start-ups incubated by Frost Data Capital, LLC ("FDC"), an entity wholly-owned by Mr. Frost.  Start-ups paid incubator fees to FDC.  The SEC complaint alleges that these incubator fees were not properly disclosed to the investors and, in fact, were exorbitant.  As stated in the SEC press release, the fees were used to finance Mr. Frost's "extravagant personal expenses" and "lavish lifestyle", and when he ran out of money, he would create and fund new start-ups in order to obtain more incubator fees.

Section 206 of the Advisers Act Applies to All Fund Managers

The anti-fraud provisions of the Advisers Act apply to ALL investment advisers, regardless of their status with the SEC or state authorities, or the absence thereof. In particular, Section 206 of the Advisers Act states:

"It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; ...

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Further, all investment advisers owe a fiduciary duty to their clients of undivided loyalty and may not engage in any activity that conflicts with the interests of their clients without their prior consent.  As held by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the advisers owe to their clients a duty of good faith and full and fair disclosure of all material facts and a duty to avoid misleading them.

According to the complaint, FDC (wholly-owned by Mr. Frost) was financially dependent on the incubator fees paid by portfolio companies.  FDC charged the portfolio companies $21.69 million in incubator fees.  None of that money went to the investors.  In the fund disclosure materials, Frost and his management company either completely omitted the existence of such incubator fees or misled the investors by saying that FDC would charge incubator fees on a case-by-case basis and at below-market rates.  In reality, every portfolio company was charged with such fees, which were $30,000 - $40,000 per month per portfolio company.  The fees had to be paid even if the portfolio company moved out of FDC's offices.  The service contracts could be canceled only upon a 180-day notice, which meant that the startups had to pay for an additional six month period.  Unsurprisingly, these ongoing payments reduced the chance of the startups to succeed, as they were quickly running out of cash.  Overall, there were 24 portfolio companies.  As of 2018, only several remained active.

ERAs Must File with the SEC 

According to Section 202(a)(11) of the Advisers Act, an "investment adviser" is any person that (1) for compensation (2) is engaged in the business of (3) providing advice (4) as to the value of securities or advisability of investing in, purchasing, or selling securities.  The Advisers Act mandates that all investment advisers must register with the SEC, unless exempt or prohibited to do so.  

A fund adviser may be exempt from registering with the SEC if it is an adviser solely to private funds with total AUM under $150 million and that are (i) venture capital funds (Section 203(l) of the Advisers Act) or private funds relying on Section 3(c)(1) or 3(c)(7) exemption under the Investment Company Act (Section 203(m) of the Advisers Act).  Such fund managers must still file Form ADV with the SEC, but a shorter version.

There is also a duty to file annual updates of the Form ADV.  Frost Management Company failed to renew its ERA filing in 2018 and onwards.

In conclusion, this case reminds us that the SEC has jurisdiction over all investment advisers, including the ERAs and the unregistered advisers.  Being an investment adviser, registered or not, big or small, carries the fiduciary duty of good faith and full and fair disclosure that should not be taken lightly.  

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Friday, August 2, 2019

How Using the Word "MAY" Instead of "WAS" Can Cost You $100 Million

On July 24, 2019, the SEC charged Facebook Inc. $100 million for inaccurately disclosing the risk of misuse of user data.  Facebook agreed to pay, without admitting or denying any wrongdoing.  So, what happened?

According to the SEC complaint, the Facebook public filings (such as the annual reports on Form 10-K or the quarterly reports on Form 10-Q, etc.) informed the public that "our users' data MAY be improperly accessed, used or disclosed" (emphasis added), but in fact, at that time Facebook already knew that it was true.  It all goes back to the infamous Cambridge Analytica scandal (CA paid an academic to collect and transfer from Facebook certain data in violation of the Facebook policies).  Later, CA used such data for clients' political campaigns.  According to the SEC complaint, Facebook discovered the misuse by December 2015 but failed to correct its public company disclosure until May 2018.

This was a material risk, and in Facebook's case, it became a reality.  However, the company did not move it from the category of "possible risks" to the category of "real events".  Rule 10b-5 under the Securities Exchange Act (like Section 17(a)(2) of the Securities Act which is near identical) prohibits companies to make "any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...".  Most securities lawyers know this phrase verbatim.   Perhaps, there was a question of whether such information was "material" to Facebook's stockholders (there are ongoing debates about the materiality standard, although in this case misusing data of 30 million Facebook users does sound "material").  Perhaps, Facebook management did not actually know about what was happening or was in disbelief.  Perhaps, some people knew but failed to communicate it to others with the disclosure-making responsibilities.  Whatever the explanation is, the fact remains that after Facebook finally publically announced that it knew about the data breach, its share price dropped, underscoring the importance of this information.  Well, this turned out to be a costly misuse of the three letters MAY. 

Drafting disclosure documents is not creative writing.  This skill is rooted in the deep understanding of the legal standards, the industry, the company, and the specific risks the company faces.  It is also based on the information that is being made available to the drafter.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Tuesday, July 30, 2019

Utility Tokens Exist

On July 25, 2019, the SEC issued its second no action letter that enables a company to generate and sell digital tokens that are not "securities" within the meaning of the US securities laws.  This no-action letter provides a no action relief to Pocketful of Quarters, Inc. ("PoQ") that intends to sell Quarters (its native digital tokens) to gamers for use in connection with playing games of the participating developers on their platform.  Just in April of this year, the SEC issued a similar no action letter to TurnKey Jet, Inc.

Below are my observations regarding this no action letter and token issuance in general:
  • This second no action letter helps us delineate the universe of utility tokens.  They are not just a concept that was abused and misused in the 2017-2018 ICOs.  Utility tokens can legally exist within the legal framework of the US laws.    
  • If previously the SEC had only shown us the instruments that cannot be utility tokens (through its cease and desist orders and various enforcement actions), then now, for the second time, we are shown examples of tokens that can be and are utility tokens.  This is incredibly useful guidance when advising clients on how to structure their tokens.
  • PoQ financed the development of its gaming platform through the issuance and sale of Q2 TOkens that were treated as "securities".  The Quarters that are subject to this no action letter are being issued after the platform development has been completed.  Again, this approach (issuing two types of tokens) can be used by others when conducting their token offerings.  
  • Quarters are not redeemable by gamers.  Once purchased, Quarters can only be used within the platform to play games, purchase upgrades, and participate in tournaments.  The only persons who can redeem the Quarters are the participating pre-approved developers and influencers who can earn the tokens by developing games and marketing them to the gamers.
  • Quarters will be sold at a fixed price, and there will be an unlimited supply of them.  This means that there will be no price speculation and no shortage that could affect the price.
  • Quarters cannot be transferred to other gamers, and therefore Quarters cannot be, and will not be, traded on secondary markets.  This means that gamers would not be purchasing the tokens with an expectation to make a profit.
  • Quarters will be sold only for the gamers' personal use within the gaming platform.  
  • Quarters will not be marketed to the public as an investment, and PoQ will make corresponding disclosures in its marketing literature.
As described in the thorough and well-written incoming letter, the Quarters present an example of true utility tokens that others may be tempted to replicate.  However, it is important to remember that only the recipient of the no action letter can legally rely on it.  Other tokens will have different features that may or may not support the legal outcome that these tokens are not "securities".  But still, the PoQ no action letter presents a good model of how to structure an offering of utility tokens that should be studied by the future token issuers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.